In dealing with the corporate business process, taxes are always an issue. The n

Question

In dealing with the corporate business process, taxes are always an issue. The number one business objective is to pay as little tax as possible while adhering to the law. Reduction of taxes can be achieved through the moving of goods between one company and another. Once this occurs, the act is known as Transfer Pricing. Based on this information, please answer the following questions:

•Please describe the transfer pricing concept.

•Please state two examples where transfer pricing is used in common business.

•What are the tax and regulatory concerns surrounding the transfer pricing process?

Explanation / Answer

Answer

The transfer pricing concept

Transfer prices are the prices charged for sale of physical goods and intangible property and/or provision of services.

Transfer pricing refers to establishing arm’s length prices charged or paid upon the transfer of physical goods and intangible property or supply of services in transactions undertaken between associated enterprises located in the same or different tax jurisdictions.

Transfer prices in case of intra-group transactions, include payments for intra-group services and intra-Group transfers of technology

For a multinational Group, transfer pricing is a means whereby the receipts from end-sales of Group products are directed to provide a contribution to the constituent members of the Group in compensation for the contributions made by their activities to the sale value of the product to independent third parties.

Two examples where transfer pricing is used in common business

Example 1

Intangible properties relating to distribution channels and quality control know-how

Key point

This case illustrates the treatment of global distribution channels and original quality control know-how.

(Summary of business of corporation and foreign-related party)

Japanese corporation P is a manufacturer and distributor of product A, and 20 years previously it established company S in country X as a subsidiary to manufacture product A.

(Summary of foreign-related transactions)

Company P sells part “a” for product A to company S, and S procures raw materials and other supplies in country X to manufacture product A, which it then sells entirely to company P. Company P sells its purchases of product A from company S in Japan and throughout the world. As production of product A consists of typical process industry operations, fixed costs account for a large proportion of the cost of manufacture and thus scale merit can be realized.

(Functions and activities of corporation)

Company P was quick to establish operations overseas. It has established sales branches in countries around the world following detailed market research to identify the most promising markets, and it also does business through agents in countries where it does not have its own marketing operations. Its global distribution channels, which is more broadly developed than that of corporations engaging solely in routine activities, have given company P’s business group a large global market share.

In order to further expand its distribution channels into new countries, its marketing and sales promotion division leads development of business strategy suited to market needs in each country.

(Functions and activities of foreign-related party)

Company S has a separate quality control division from its manufacturing division, and over 10% of its workforce is engaged in checking products and inspecting production lines in order to maintain quality of product A. Company S’s quality control division has accumulated know-how on dealing with and solving the quality problems that have arisen in the course of its 20 years of manufacturing experience. Using its developed unique inspection techniques and testing equipment, it checks quality and production lines at each of the key stages of production, and any problems that do occur during manufacturing are immediately rectified based on such know-how. This unique quality control setup dramatically increases inspection efficiency, and also reduces the cost of manufacture by reducing spoilage at company S and reduces product complaints from end users concerning product A, which has consequently acquired a reputation for reliability. As a result, a superior sales position has been achieved.

Treatment for transfer pricing taxation purposes

Regarding the foreign-related transaction in this case, it was found that the attainment of high sales through the global distribution channels created by company P (resulting in higher profits as sales increase due to the high proportion of fixed costs in the cost of manufacture) and the establishment of a superior sales position (as a result of reduced loss due to spoilage in the cost of manufacture and the lower incidence of faults due to company S’s original quality control know-how) served as a source of income in company P and company S’s foreign-related transactions compared with in the cases of a corporation engaging solely in routine activities.

Explanation

Corporations ordinarily have some kind of distribution channels (even those engaging solely in routine activities), and also engage in some form of quality control in manufacturing, and so the existence of distribution channels and engagement in quality control cannot be immediately deemed to serve as a source of income in a foreign-related transaction compared with in the cases of a corporation engaging solely in routine activities. However, they may serve as a source of income in a foreign-related transaction if the distribution channels are broader and unique or quality control know-how is more unique than with corporations engaging solely in routine activities.

Examples 2

Treatment of profits affected by market features and market fluctuations

Key point

This case illustrates the application of the residual PS method when factors such as market features and market fluctuations are deemed to have an impact on the profits of the corporation or foreign-related party.

(Summary of business of corporation and foreign-related party)

Japanese corporation P is a manufacturer and distributor of product A, and 10 years previously it established corporation S in country X as a subsidiary to manufacture and distribute product A. Product A is produced using original technologies resulting from R&D led by company P.

(Summary of foreign-related transactions)

Company P sells part “a” (a core part that aggregates company P’s original technologies) to company S, and also licenses to company S patents and manufacturing know-how (original technologies created as a result of company P’s R&D activities) for the manufacture of product A. Company S combines part “a” with other parts to manufacture product A, which it sells to a number of third-party agents in country X.

(Functions and activities of corporation and foreign-related party)

Product A, which is the outcome of R&D led by company P, has seen sales increase due to its unique technical performance, and it has achieved a certain market share in country X. Company S also has a technology development division consisting of about 10 engineers and performed some of the development for product A, contributing to achieving product A’s unique technical performance in conjunction with R&D by company P. Company S does not engage in original advertising or sales promotion activities, and it does not use its own trademark in marketing.

(Market conditions)

The product A industry to which company P’s business group belongs is known for being subject to severe fluctuations globally, and fluctuations in demand are considered to give rise to a regular cycle in companies’ profits. In practice, company S’s actual operating margin and the operating margins of corporations in the same industry in Japan, the world, and country X according to databases of corporate data have exhibited largely the same cycle over the past 10 years. While the industry’s average level of profit in country X is higher than the world average, this is due to the market price for product A in country X being kept somewhat higher than the international average on account of government price regulation.

Treatment for transfer pricing taxation purposes

As the result of comparability analysis, no comparable transaction was found for any of foreign-related transactions (sales transactions of parts “a” and licensing of patents). The following results were obtained from the analysis. As company P and company S were found to have intangible properties serving as a source of income in their respective foreign-related transactions compared with in the cases of a corporation engaging solely in routine activities, and to make the unique and valuable contribution in the foreign-related transaction, it was deemed appropriate in this case to select a consistent with the residual PS method as the most appropriate method, and to calculate the arm’s length price. Three factors that could potentially affect company S’s operating margin are: (1) intangible properties created by company P and company S’s R&D activities; (2) fluctuations in demand arising from cyclical changes in market conditions; and (3) the level of the market prices in country X. Regarding (2), however, the average profit margin in the industry follows the same trend in Japan, country X, and the world, and corporations belonging to the same industry typically enjoy the same margin, while regarding (3), the industry’s average profit margin in country X is comparatively high compared with the global level, and is thought to be enjoyed uniformly throughout the industry in country X. When applying a method consistent with the residual PS method, therefore, the impact of fluctuations in demand and the level of the market prices is reflected in the calculation of company S’s routine profit by selecting a routine transaction based on financial information of appropriate corporation in country X considered to experience similar effects.

Explanation

Fluctuations in demand and market prices and the effect on price levels arising from peculiarities of the market would have a similar impact on corporations doing business in the same market. When applying the residual PS method, therefore, the impact on prices of fluctuations in demand and market prices and features of the market (such as customer preferences and government price regulation) is reflected in calculations of routine profit provided that a routine transaction is selected based on financial information of appropriate corporation and that the financial data for the same period is used.

The tax and regulatory concerns surrounding the transfer pricing process

Section 482 – U.S. Internal Revenue Code

Five methods

Licenses of intangible property

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